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Trade and production

The fundamental law of production is that joint production yields a greater return than isolated production. Two individuals working in isolation from one another produce less physical goods and services than if they coordinated their efforts. This is probably the most momentous fact of social life. David Ricardo first formulated this law as a law of comparative cost within the context of the theory of foreign trade. Later economists such as Pareto, Edgeworth, Seligman, and Mises argued that it was in fact a general law of exchange. Mises coined the expression “law of association.” Even if there were no other reasons for human beings to cooperate, the greater productivity of joint efforts, compared to isolated production, tends to draw them together.[1]

Opportunity cost and trading

For example, Amy can produce either one hundred oranges or ten tires in a day while Chen can produce ten oranges or two tires in a day. It doesn't look like they have anything to gain by trading: Amy is much more productive than Chen.

But compare their opportunity costs - what you have to give up to get something else. To produce one hundred oranges, Amy gives up the opportunity to produce ten tires. Her opportunity cost of an orange is one tenth of a tire, and her opportunity cost of a tire is ten oranges. Chen's opportunity cost of an orange is one fifth of a tire, and her opportunity cost of a tire is five oranges.

In terms of tires, it is cheaper for Amy to produce oranges because she only gives up one tenth of a tire to produce an orange while Chen has to give up one fifth of a tire. In terms of oranges, it is cheaper for Chen to produce tires because he only gives up five oranges to produce a tire while Amy gives up ten oranges to produce a tire.

They can both have more oranges and more tires if they specialize and trade. Chen can offer Amy one tire in exchange for seven oranges. Chen would be better off because he would get seven oranges in exchange for one tire, while he would only get five oranges for one tire if he produced them himself. But this is attractive for Amy too, because she can get a tire for only seven oranges, which is fewer than the ten oranges she would have to give up if she produced tires herself. At any "orange price" of tires between five and ten, Amy and Chen are both better off.

The same logic is valid for countries - countries are also better off if they can specialize and trade.[2]

Direct exchange

Jones can trade his apple against two eggs from Brown. In such a world, the volume of exchanges—in other words, the extent of social cooperation—is limited through technological constraints and through the problem of the double coincidence of wants. Barter exchanges take place only if each trading partner has a direct personal need for the good he receives in the exchange. But even in those cases in which the double coincidence of wants is given, the goods are often too bulky and cannot be subdivided to accommodate them to the needs. Imagine a carpenter trying to buy ten pounds of flour with a chair. The chair is far more valuable than the flour, so how can an exchange be arranged? Cutting the chair into, say, twenty pieces would not provide him with objects that are worth just one twentieth of the value of a chair; rather such a "division" of the chair would destroy its entire value. The exchange would therefore not take place.[3]

Indirect exchange

If a person desires a good with the intention to trade it away to someone else, then he is engaged in indirect exchange.

With the possibility of indirect exchange, goods are valued not only by their direct use-value but also their exchange-value. An actor will always value a unit of a good at the higher of these two. (For example, even a non-smoker can prefer a box of cigars over a hot dog, if he thinks he can trade the former to a smoker.)[4]

The benefits of trade

In a voluntary exchange is the valuation of goods different and reverse: each party values what is given up less than what is received in the exchange. Because individuals value goods differently, there are mutual "gains from trade". Both parties benefit from a voluntary exchange (or at least expect to).[4]

Most philosophers in the history of the world, including Aristotle, have missed this point. They believed that exchange takes place when valuation is equal or in proportian. But that is just wrong: if two people value goods equally, an exchange would never take place, since no individual could be made better off than before. People would be wasting time engaging in it at all. The discovery of the correct theory of exchange had to wait until the late Middle Ages when the followers of St. Thomas Aquinas saw the logic for the first time. They saw that economic exchange was mutually beneficial, with each party to the exchange seeing an increase in personal welfare, subjectively perceived. The action of exchange on its own becomes a means of increasing the well-being of all people. Even if there is no new physical property available, no new innovations, no new productivity, wealth can be increased by the mere fact of exchange-based human associations.[5]

Trade also fosters specialization and the division of labor. By specializing in activities in which they are relatively most productive (or have the comparative advantage), actors greatly increase the productivity of their labor and enjoy more consumption goods than would be possible without trade.[6]

Free trade

A voluntary action—free exchange leads to the mutual ben­efit of both parties to the exchange. Indirectly, the network of these free exchanges in so­ciety — known as the "free market" — creates a delicate mechanism of harmony, adjustment, and precision in allocating productive resources, deciding upon prices, and gently but swiftly guiding the economic system toward the great­est possible satisfaction of the desires of all the consumers. In short, not only does the free market directly benefit all parties and leave them free and uncoerced; it also creates a mighty and efficient instrument of social order.

On the other hand, coercion has diametrically opposite fea­tures. Not only does coerced exchange mean that some live at the expense of others, but, indirectly, coercion leads only to further problems: it is inefficient and chaotic, it cripples production, and it leads to cumulative and unforeseen difficulties. Seemingly orderly, coercion is not only exploitative; it is also profoundly disorderly.[7]